Where Are We Versus Where Are We Going
operation twist - on again, off again, on again
investmentrarities.com
US retail sales and the University of Michigan Consumer sentiment survey will be out Friday. Following the terrible production and employment numbers announced last week these numbers will be very important in determining investor sentiment moving forward. If the numbers are weak it will be viewed by an increasing number of analysts as validation that the economic fundamentals are still weakening in the US and are more important than the war rally as a predictor of economic activity. Most analysts however, right now, believe that the numbers will be stronger than last month and will thus signal that the war and the lead up to it represented near term bottoms for the consumer. In other words these numbers will be critical to defining how the markets see the future prospects for all economic activity in the US and in determining the near term direction for the stock markets of the world. Good numbers will validate the equity and corporate bond run of the last few weeks and propel them even higher. Weaker than expected numbers will raise concerns over the economic fundamentals and cause questions to be raised about the validity of the promise made by wall street and the central banks that the war was the problem holding the economy back and that their will be a surge in consumer and capital spending following it. Although I hope the numbers are positive I suspect that they will be weaker than expected.
If the numbers are weaker than expected
If the economy does not begin to pick up as promised the FED will have to stimulate the economy further. As the FED funds rate is at 1.25% the FED will probably begin looking to other more direct interventionist measures in an attempt to stimulate the economy. I continue to believe the FED will lower the FED funds rate in the near future and also inject more money into the banking system.
Buying Long Treasuries
However, after 12 rate cuts I believe the FED will begin directly targeting long term rates soon by outright buying of the long treasuries, maturities of 5-10 years. This will be done in an attempt, in the immediate term, to manipulate the consumer targeted borrowing rates, primarily mortgage rates, by driving down the yields on the long term treasuries. The longer term goal will be to force the banks into increasing their capital lending to companies.
As this buying becomes evident I also expect the banks and bond traders to follow through with buying long term treasuries themselves. That is until the yield spread, or difference between the cost of capital to the banks and the return they can achieve by simply buying treasuries decreases to the point that it is no longer considered preferable to lending.
The goal in doing this however is not simply to drive down the long term treasury yields and drag down consumer and mortgage rates as a result. The real goal is to lower the spread between the short term treasuries and long term treasuries and thereby make it less attractive for the bankers to buy the long term treasuries using the capital that has been injected into them by the FED. As the spread between the two rates falls, by default the risk to the banks of buying long term treasuries increases because the yield spread, or return they can make by doing so, has been reduced.
This then also makes it more likely that the banks will begin to increase their efforts to find commercial borrowers they can lend to at a greater return than buying the treasuries. The problem to date with the slow down in capital borrowing, spending and investing by corporate America is not simply that companies don't want to borrow. It is equally the fault of the banks having little incentive to lend.
The banks have been able to borrow at low short term rates and also take the capital injected into them by the FED and buy long term treasuries with a greater return than their cost of capital. A kind of arbitrage.
This, of course, defeats the purposes the FED had in mind when they lowered the overnight lending rate and injected the cash into the banks. The goal in doing so was to attract borrowers but also to lower the risk of lending to the banks. This has not worked.
Because of this I believe the FED will have to take a more active role in intervening in the normal relationship between banks and borrowers and forcibly alter their thinking by directly adjusting the rates across the entire yield curve.
The secondary benefit of this will be that mortgage rates to consumers drop immediately following this intervention.
Impact on Gold and dollar
There will also be an impact on gold. As the FED injects more money into the banking system and forces it into circulation by way of making it impractical for the banks to park money in treasuries and instead having to lend it, the true money supply will grow.
With the growth of the money supply comes and automatic and immediate depreciation of the dollar versus the euro, yen and gold. This should help drive gold prices higher. To what extent this occurs and to what level it helps gold to get to I can not say. It should however not result in a dramatic shift immediately. |
